Strategic Trading, Welfare and Prices with Futures Contracts

Abstract

I study the effects of allowing futures contracts on an asset in a dynamic market when competition is imperfect. I first show that imperfect competition creates a market incompleteness: by delaying trade to mitigate price impact in the spot market, buyers (sellers) face the risk that the price unexpectedly increases (decreases) due to a supply shock. Futures with maturity shorter than traders' horizon would allow them to share this risk. Second, I show that once futures are introduced, traders want to manipulate their payoff: long futures want to buy the asset at maturity to raise the spot price, and conversely for shorts. In equilibrium, traders choose negative hedge ratios because of manipulation: spot sellers (buyers) buy (sell) forward, and reduce their positions when volatility is higher. Unless manipulation is impeded, traders traders are better off without futures. Third, because of imperfect competition, the spot price can be below or above the futures price, depending on supply shock expectation: an arbitrage opportunity arises without market segmentation.